Are positive reactions to bad news plausible? the consideration of fraud detection in audit and reporting delays

Yim, Andrew (2011): Are positive reactions to bad news plausible? the consideration of fraud detection in audit and reporting delays.

Abstract

I formulate a model to emphasize the fraud detection role of auditors in the financial market and relate the role to audit and financial reporting delays. The model focuses on asset misappropriation fraud, which is one of the two types of fraud US and international auditing standards require auditors to consider. In the model, an auditor considers whether to perform extended audit procedures after observing a red flag generated from regular audit procedures. An audit delay is represented by the event of extending audit procedures and manifested as a financial reporting delay observed by the market. I derive a simple closed-form condition characterizing when a positive market reaction to a delay is possible. The condition provides a theoretical basis for formulating empirically testable hypotheses. I discuss why the fundamental logic behind the counter-intuitive positive-reaction condition also applies to accounting fraud, as well as other contexts (e.g., internal control weakness disclosure). Documented evidence in the literature suggests that “positive reactions to bad news” (PR2BN) is a general phenomenon. Other empirical implications of the model, with suggestions for regression equation specifications, are also discussed.

• Item Type: MPRA Paper
• Language: English
• Keywords: Audit delay, financial reporting lag, extended audit, red flag, fraud detection, SAS 82, SAS 99
• Subjects: G - Financial Economics > G3 - Corporate Finance and Governance > G32 - Financing Policy ; Financial Risk and Risk Management ; Capital and Ownership Structure ; Value of Firms ; Goodwill; M - Business Administration and Business Economics ; Marketing ; Accounting ; Personnel Economics > M4 - Accounting and Auditing > M42 - Auditing; K - Law and Economics > K4 - Legal Procedure, the Legal System, and Illegal Behavior > K42 - Illegal Behavior and the Enforcement of Law; M - Business Administration and Business Economics ; Marketing ; Accounting ; Personnel Economics > M2 - Business Economics > M21 - Business Economics

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